Current Developments in S Corporations (Part I)

Various tax bills have included a far-reaching
tax proposal that would impact many large and
small professional service S corporations. None
has been enacted yet.

The government has released preliminary
information about the National Research Program
regarding S corporations audited for tax years
2003 and 2004 and announced a new NRP related to
compensation and S corporations.

Sec. 1374(d)(7) was enacted, which exempts for
2009 and 2010 Sec. 1374’s built-in gains tax
imposition if the S corporation is in its eighth,
ninth, or tenth year of the recognition period.

During the period of
this S corporation tax update (July 9, 2009–July 9, 2010),
numerous developments occurred in the area of S corporation
taxation. This two-part article discusses recent
legislation, cases, rulings, regulations, and other
developments in the S corporation area. Part I covers new
tax laws, court cases, regulations, revenue procedures, and
rulings on various S corporation operating provisions.

Zero Capital Gain Rate in 2009 and 2010

The
potential zero capital gain rate for 2009 and 2010 continues
to be an attractive tax planning tool that may affect S
corporations and their shareholders’ behavior. Because the
capital gain tax rate for individual taxpayers in the lower
two tax brackets is zero in 2009 and 2010,1
many taxpayers are (or were) gifting appreciated
S corporation stock to their children, grandchildren, or
parents. In 2008, the tax law extended the kiddie tax to
income (including capital gains and dividends) of
18-year-olds who do not provide more than half of their
support and to 19- to 23-year-olds who are full-time
students2
and do not provide more than half of their own support.3
Thus, the 0% tax rate generally will not be available to
students through age 23 unless they have significant earned
income or possibly trust fund income that contributes to
their own support. This leads to a balancing act. Parents
may hire a child to legitimately work for them and pay him
or her enough to meet the 50% self-support test but not so
much that they exceed the first two bracket limits ($34,000
for single taxpayers in 2010), including the capital gains
generated. (The parents will also lose the dependency
exemption.)

Example 1: Child
C, age 22, is in
graduate school and has $5,000 dividend income and $2,000
ordinary income from an S corporation, plus $10,000 earned
income from summer work and from helping his parents with
computer work in their business. His total support is
$18,000. In March 2010, C’s parents give him
stock worth $26,000, with a basis of $6,000 and a holding
period of at least one year. He has a standard deduction and
personal exemption that puts his 2010 taxable income in the
first two tax brackets. Assuming that C sells the gifted stock
in 2010, he will pay no tax (0% tax rate) on the $20,000
capital gain and the $5,000 dividend income, for a tax
savings over his parents’ hypothetical tax on the dividend
and capital gains of $3,750 ($25,000 × 15%).

Example 2: The
taxable income limit for the first two brackets for a
married couple in 2010 is $68,000. Couple A and B, who are retired, defer
pension distributions and invest primarily in tax-exempt
bonds, and they live off the interest. Their S corporation
Schedule K-1 shows ordinary income of $40,000, and they
receive distributions of $50,000 during the year. They have
itemized deductions of $30,000. Their net ordinary income is
$10,000 ($40,000 – $30,000). Therefore, if they recognized
$200,000 in capital gains or dividend income through the S
corporation or otherwise, $58,000 of the gain would be
subject to a 0% tax rate. The other $142,000 would be
subject to the normal 15% tax rate. This results in a
federal tax savings of $8,700.

IRS Audit Rates and
NRP Studies

The IRS released its yearly statistical
report that includes details about its audit rates from the
last quarter of 2008 through the first three quarters of
2009. In addition, the IRS has released preliminary
information about the National Research Program (NRP)
regarding S corporations audited for tax years 2003 and 2004
and has announced a new NRP on compensation, independent
contractors, etc., relative to S corporations.

IRS Audit Rates

To put S corporations
and their individual shareholders’ audit rates in
perspective, it helps to see what other business entities’
audit rates are. For the audit period October 1,
2008–September 20, 2009, the results were generally slightly
lower than the prior audit period, with the exception of
Schedule Cs with more than $200,000 of gross revenue, which
was significantly higher. For C corporations with less than
$10 million of assets, the audit rate was 0.9%, while those
with more than $10 million of assets were audited 14.5% of
the time. This is to be contrasted with S corporations and
partnerships, which had a 0.4% audit rate. For individual
tax returns, 1.4 million out of 154 million filed were
audited, for a less than 1% audit rate. Farm activity was
audited at a 0.3% rate, while Schedule C businesses with
less than $25,000 in gross receipts were audited at a 1.1%
rate. Those Schedule C businesses with $25,000 to $100,000
in gross receipts were audited 1.9% of the time, those with
$100,000 to $200,000 in gross receipts were audited at 4.2%,
and those over $200,000 at 3.2%.

NRP on
S Corporations

At an IRS Tax Research Conference
(July 8–9, 2009), the preliminary results of the National
Research Program on S corporations, which audited 1,200 S
corporations for tax year 2003 and 3,700 for tax year 2004,
were reported. The program found 12% underreporting for 2003
and 16% for 2004. It also discovered that small S
corporations (defined as having less than $200,000 in
assets) had a higher percentage of underreporting than large
S corporations. The results showed that this underreporting
mirrored underreporting by Schedule C businesses.

New NRP on Wages and Self-Employment Taxes

Tax advisers should be aware of a new NRP being planned
for 2010–2012 (2,000 returns per year) that will focus on
employment status: employee vs. independent contractor,
reasonable compensation, S corporation distributions vs.
salary, and matching taxpayer identification numbers. Of the
2,000 returns, 1,500 per year will be from the Small
Business/Self-Employed (SB/SE) division. The program began
in February 2010.

The Watson case4
represents exactly what the government is trying to ferret
out with this new NRP. A seasoned professional (in this case
an accountant) worked 35–40 hours per week, 46 weeks a year,
but took a salary of only $24,000. In addition, he
distributed more than $200,000 in cash to himself. This
taxpayer behavior echoes a long line of cases going back to
Radtke,5Spicer Accounting
Corp.,6Joseph M. Grey Public
Accountant,7
etc., in which the taxpayers all failed in their attempts to
avoid paying Social Security taxes by undercompensating
themselves and taking the money out as distributions.
Unfortunately this behavior, especially given the current
situation of serious budget deficits and Congress hunting
for revenue sources, has led to a serious threat to an
advantage S corporations have over partnerships.

Having a much larger possible impact on S corporations is
a provision that was embedded in various versions of tax
extender legislation that would subject certain S
shareholders to self-employment (SECA) taxes on their
pro-rata share of S income or loss (other than, for example,
interest, dividends, capital gains, or real estate
investments). The provision would apply to S corporations
that are principally partners in partnerships that are in a
professional service trade or business if substantially all
the S corporation activity is conducted by the partnership.
It would also apply to an S corporation engaged in a
professional service business if the principal asset of the
business is three or fewer employees’ skills and
reputations. The definition of a professional service
business is much broader than existing law defines it. It
includes the normal professions of medicine/health, law,
accounting, engineering, architecture, and actuarial
services and expands it to include lobbying, performing
arts, athletics, investment advice, and management or
brokerage services as well as consulting. The effective date
of this provision, if enacted, would be tax years beginning
after December 31, 2010. This provision also attributes the
pro-rata share of income or loss of any relative defined in
Sec. 318(a)(1) to the professional service provider. Such
relatives include a spouse, parent, child, or
grandchild.

Example 3: D, a doctor, owns
4% of an S corporation medical practice, and C, his son (a
nonphysician), owns 40%. The other 56% is owned by two other
doctors. Because 60% of the assets are related to three or
fewer owners’ skills, this S corporation is considered a
“disqualifying S corporation” subject to these proposed new
SECA rules. No matter how fair the salaries were in the
past, beginning in 2011 C’s pro-rata income would
be attributed to D
for SECA purposes (but not for income tax purposes).

Proposed Tax Return Disclosures

On January 26,
2010, IRS Commissioner Douglas Shulman made a surprise
announcement that for large and mid-size business (LMSB)
entities (more than $10 million in gross assets), for tax
returns in tax years beginning in 2010,8
the business entity will need to disclose uncertain tax
position information. This proposal was supposed to include
S corporations; however, only S corporations that have
built-in gains tax, excess net passive income tax, or
questionable S status would have been subject to these
rules.9
The friction between substantial authority (40% probability)
to sign a tax return by a preparer and the
more-likely-than-not (greater than 50%) criterion of FIN
4810 will obviously cause issues
between auditors and their clients as well as between the
IRS and the company’s representative. There may be more
spin-offs to avoid LMSB status. However, for now the new
Schedule UTP does not need to be filed by S
corporations.11

Due Dates of Flowthrough
Entity Tax Returns

Calendar-year extended
partnership and trust tax returns for 2009 were due
September 15, 2010. The AICPA is petitioning Treasury and
Congress to modify original due dates and extensions
relative to passthrough entities to make the busy season a
bit more sane and logical. Under this proposal,
calendar-year partnership returns would be due March 15,
with extensions due September 15. The theory is that many
other entities require the Schedule K-1 from partnerships to
file their own returns. Calendar-year S corporation returns
would be due March 31, with an extension to September 30.
Trust returns would be due April 15, with extensions due
September 30. Individual and C corporation returns are
proposed to be due April 15 and October 15. However, these
changes are just proposals at this point. Any change to the
original due dates requires congressional action, but
changes to extension dates are the prerogative of
Treasury.

Health Care Legislation

The health
care legislation12 effective in 2013 requires an
additional 0.9% Medicare tax on employees (but not
employers) on the combination of wages and self-employment
income that exceeds $250,000 (married taxpayers filing
jointly) or $200,000 (single taxpayers).13
There is no self-employment deduction for this
amount as it is an employee burden. Payment of estimated
taxes would be required.

In addition, the new law
imposes a post-2012 3.8% Medicare tax on the lesser of net
investment income or modified adjusted gross income (AGI)
greater than $250,000 (married taxpayers filing jointly) or
$200,000 (single taxpayers).14
Again, estimated taxes would be due on this
amount. This brings up several issues about what constitutes
investment income: Rental and royalty income? Yes. Capital
gains, interest, dividends, and annuities? Yes. S
corporation and partnership income? Only for passive
investors in an active trade or business. Tax-exempt income?
No, because this concept is based on gross income. Pension
plan distributions? No.15 These rules will apply to
individuals, trusts, and estates.16

Example 4: H and W have $1 million in
wages, $150,000 in net investment income, and modified AGI
of $900,000 in 2013. They will owe an additional $6,750
($750,000 × 0.9%), plus 3.8% × the lower of $150,000 or
($900,000 – 250,000) = $5,700. Thus, the total tax increase
would be $12,450.

Example 5: J and M, a married couple, have
a combined self-employment income and salary of $230,000,
net investment income of $40,000, and modified AGI of
$260,000 in 2013. They will owe no additional salary tax
because their earned income is below $250,000. They will owe
net investment income tax to the extent of the lesser of
$40,000 or $10,000 (260,000 – 250,000); $10,000 × 3.8% =
$380.

HIRE Act

The HIRE Act17 extended to 2010 the increased
$250,000 limit on the amount of the Sec. 179 expense
deduction and the $800,000 phaseout threshold for the
deduction. Interestingly, it did not extend the 50% bonus
depreciation. It also provided a payroll (Social Security)
tax holiday for employers for each new nonrelated hire that
has been unemployed 60 days or longer.18 As an additional sweetener, if
the employee continues to be employed for 52 weeks, there is
a $1,000 credit.19

Other S Corporation
Current Operating Developments

Losses
and Limitations

A major motivation for a corporation
choosing S status is the ability to flow entity-level losses
through to its shareholders. There are several hurdles a
shareholder must overcome before losses are deductible,
including Sec. 183 (hobby loss), Sec. 1366 (adjusted basis),
Sec. 465 (at risk), and Sec. 469 (passive activity loss)
rules. Several court cases and rulings were issued relative
to these loss limitation rules.

To nobody’s great
surprise except the taxpayer, guaranteeing a loan does not
create basis for purposes of deducting an S corporation loss
until the shareholder fulfills the guarantee. In Weisberg,20 the shareholders argued
increased basis, and the court not only disallowed the loss
but imposed Sec. 6662 penalties, stating that there was no
substantial authority—or even reasonable basis—and there
clearly was no good-faith position.

In a clever
attempt to increase basis for loss, two brothers tried a
unique strategy.21 They made a capital
contribution of $1.4 million to their S corporation and
argued that this contribution was tax-exempt income under
Sec. 118 and therefore increased their basis in debt. They
then paid off that debt, the basis of which had been reduced
by entity-level losses. By increasing their basis in the
debt, the brothers argued, they should not be taxed on the
note repayment. Neither the Tax Court nor the Second Circuit
allowed the capital contribution to increase their basis in
the debt.

Penalties for Nontimely
Filing of Form 1120S or Missing Information

In what
will probably be a surprise to many tax practitioners, the
Mortgage Forgiveness Debt Relief Act of 200722
enacted a new provision that imposes a penalty of
$85 per shareholder per month (not to exceed 12 months) if
the S corporation does not timely file its corporate return
or fails to provide information required on the return.23 The law is effective for 2007
Forms 1120S, U.S. Income Tax Return for an S
Corporation,24 and is imposed on the S
corporation. For returns required to be filed after December
31, 2008 (2008 Forms 1120S), the penalty was raised to $89
per shareholder per month.25 The Worker, Homeownership, and
Business Assistance Act26 (signed into law on November
6, 2009) upped the Sec. 6699 penalty to $195 beginning for
late filing or nondisclosing S corporations in 2011.

For purposes of computing the amount of the penalty,
shareholder husbands and wives count as two; the act counts
the sale or gifting by one shareholder to another as two
different shareholders. It is unclear how it would treat
community property state ownership where actual ownership
may be in one person’s name.

Example 6: H and W and their two children
own all the stock of XYZ Corp. In October
2009, the two children gift some stock to their spouses. In
2010, the S corporation forgets to include the distribution
amount on the Schedules K and K-1 on the 2009 Form 1120S.
The S corporation could be liable for a penalty of $6,408
($89 × 6 × 12) for this innocent mistake.

What is
particularly disturbing about this provision is that, in the
authors’ experience, rarely if ever is the date of
distributions included on Schedule K and related K-1s. Yet
according to Secs. 6037(a) and (b), this information is
supposed to be reported to the government and the
shareholders.

Built-in Gain Tax
Holiday

The American Recovery and Reinvestment Act of
200927 enacted Sec. 1374(d)(7), which
has somewhat reduced the stress and impact of Sec. 1374 for
2009 and 2010. This provision exempts Sec. 1374’s built-in
gain (BIG) tax from being imposed if the S corporation is in
its eighth, ninth, or tenth year of the recognition period.
Nonetheless, there are some tax planning or unanswered
questions that need to be considered. For example, if an
installment sale of BIG property occurred in a prior year,
it may be advisable to recognize the gain in 2009 or 2010,
assuming it qualifies as an eligible year. It may even be
prudent to trigger the installment gain by using the
installment note as collateral for a loan.

If the
taxpayer’s net recognized BIG is limited by taxable income
in its eighth recognition period year (2009) and in 2011 it
is subject to BIG, is the 2009 suspended gain forgiven or
subject to Sec. 1374 tax? There also seems to be a
difference between which years qualify as eighth, ninth, or
tenth for Sec. 1374 vs. the carryover basis rules of Sec.
1374(d)(8). For the former, tax year seems to be the
criteria, so in switching from a C fiscal year to an S
calendar year a corporation may have had a short tax year.
For the carryover basis provisions, the law seems to look to
12-month periods. Former House Ways and Means chair Charles
Rangel introduced a technical correction bill28 to make the rule 12-month
periods, but it has not been enacted.

What if a
taxpayer sold an asset in 2009 or 2010 on an installment
basis that would be covered by these rules but recognized
gain in 2011? It may be prudent in this situation to elect
out of the installment sales treatment to avoid the
potential double tax in 2011 and beyond. Since the BIG
installment sales rules actually allow double tax treatment
beyond the 10-year recognition period, by treating the
installment gain as recognized in the year sold, this logic
may help to include the 2010 gain as covered by the tax
holiday. Nonetheless, it would be helpful to have some
guidance from Treasury.

Ringgold Telephone
Co.29 dealt with a C corporation
that converted to S status on January 1, 2000. It appraised
a significant partnership interest asset at $2.6 million at
the date of conversion. Seven months later, it sold the
interest for $5 million. The issue was how much of the gain
was built-in gain, with the government arguing that the sale
for $5 million so soon after the conversion must be the
value at the date of conversion. The taxpayer argued that it
received a fair valuation at the date of conversion and that
the $2.4 million appreciation in the asset occurred after
the conversion. The Tax Court made a Solomon-like decision
and split the baby in half by valuing the asset at the date
of conversion at $3.7 million. The court ruled that a recent
sale would normally help determine the true value, but in
this case the buyer had made a strategic acquisition and
avoided some right of first refusal terms that motivated the
buyer to pay a premium. The court held that his premium
should not be included in the date of conversion value.

LIFO Recapture

Letter Ruling
20101002630 presents an unusual fact
pattern. A sole proprietor on the LIFO inventory method
incorporated as an S corporation that will use the LIFO
inventory method. Is the S corporation subject to Sec.
1363(d) LIFO recapture? The answer is no because there was
no avoidance of the Sec. 1374 BIG tax, as the sole
proprietor was subject to only one tax in the first
place.

Banks and Sec. 291(a)(3)

When a corporation converts from C to S status, it needs
to be aware of the impact of Sec. 291. This provision is a
carryover from the old corporate add-on minimum tax days,
but it still applies today. For example, Sec. 291(a)(1)
requires an S corporation that sells real estate within
three years after converting to S status to characterize 20%
of the lower of gain recognized or straight-line
depreciation as ordinary income.

In Vainisi,31 a lower court held that Sec.
291(a)(3), which requires a 20% disallowance on interest
expense related to tax-exempt income, applies to a qualified
S subsidiary (QSub) bank, even more than three years after
conversion. The Seventh Circuit overturned the lower court
finding and held that Sec. 291(a)(3) applies only for three
years after the bank converted from C to S status.32

Structuring
Deals Using ESOPs

In order to sell the Chicago
Tribune tax free but still get cash, the owners of a C
corporation formed an employee stock ownership plan (ESOP)
and sold at least 30% of the stock to the trust under Sec.
1042.33 As long as the sellers
reinvested the proceeds in publicly traded stocks and bonds,
they would not recognize the realized gain on the sale to
the ESOP. The buyers then converted the C corporation to an
S corporation, where the income allocated to the ESOP would
not be taxable. However, tax professionals should be aware
of the Sec. 409(p) rules when dealing with S corporation
ESOPs, which limit the ownership of plan assets by certain
disqualified persons.

IC-DISC Tax Rate
Arbitrage

Most practitioners are aware that in the
right situation (investment interest expense being less than
net investment income), there can be a tax planning
opportunity of increasing investment interest expense and
investing in dividend-paying stocks to play the tax rate
differential. Less well known is utilizing an interest
charge domestic international sales corporation (IC-DISC) to
net the same results for companies that produce products in
the United States (more than one-half) but sell them
overseas.

IRS statistics34 show an increase in the number
of IC-DISCs from 2004 (425 taxpayers) to 2006 (1,209
taxpayers), and gross revenue increased from $5.3 billion to
$19.3 billion in that time. Considering that there are over
4 million S corporations, obviously a very small percentage
is taking advantage of these provisions.

Essentially
the IC-DISC receives commissions based on the greater of 50%
of net export income or 4% of gross revenue. Dividends to
the shareholder qualify for the Sec. 1(h) 15% tax rate, and
the producing entity corporation gets a deduction at 35%. To
sweeten the deal, the producing entity (if eligible) can use
the Sec. 199 domestic production activities deduction as
well.

QSubs and Foreign Corporations

Reflecting the increased sophistication and complexity
for which S corporations and their disregarded subsidiaries
(QSubs) are being used is a series of 14 private letter
rulings issued in 2010 dealing with 6 QSubs, a foreign
partnership, and 15 foreign corporations.35 The rulings dealt with whether
an S corporation could make a qualified election fund (QEF)
election under Regs. Sec. 1.1295-3(f) for a private foreign
investment company (PFIC) retroactively. In each ruling, the
IRS granted the taxpayer consent to make a retroactive QEF
election with respect to the foreign corporation because the
taxpayer satisfied the rules under Regs. Sec. 1.1295-3(f).
The IRS determined that:

The taxpayer had
reasonably relied on a qualified tax professional;

Granting consent would not prejudice the government’s
interests;

The request was made before the
IRS raised the PFIC status of the corporation; and

The taxpayer satisfied procedural requirements.

Corporate Division

The
flexibility engendered by the QSub disregarded entity rules
generated merger and acquisition activity involving S
corporations. In one ruling, an S corporation wanted to
simplify its corporate structure and reduce some
administrative costs, so it wished to merge a disregarded
entity into the S corporation.36 However, for various
contractual and legal reasons the S corporation could not do
an upstream merger. So instead it did a downstream merger
into its QSub in an A reorganization.37 The IRS treated this
transaction as an F reorganization.38 Adjusted basis of the
shareholders’ stock, accumulated adjustments account, and
basis in assets would all stay the same.

Another
letter ruling discusses the proper treatment of an S
corporation QSub split-off.39 Interestingly, a D
reorganization40 was required because the
disregarded entity did not count as preexisting. The
business reason for the split-off was key employee
incentives, and—a bit unusual for an S corporation without
shareholder disputes—the transaction was non–pro rata.

Part II of this article,
in the November issue, will focus on eligibility,
elections, and termination issues.

9
This is because FIN 48 disclosures would apply only to
income taxes imposed at the entity level. Announcement
2010-30, 2010-19 I.R.B. 668, makes it clear, as do the draft
Schedule UTP instructions, that S corporations are not yet
subject to the uncertain tax position disclosure
reporting.

40 A transfer of assets by the
corporation in a transaction that qualified under (in this
case) Sec. 355 (Sec. 368(a)(1)(D)).

EditorNotes

Stewart Karlinsky is a professor emeritus at San José
State University in San José, CA, and a member of the AICPA
Tax Division’s S Corporation Taxation Technical Resource
Panel. Hughlene Burton is an associate professor in the
Department of Accounting at the University of North
Carolina–Charlotte in Charlotte, NC, and chair of the AICPA
Tax Division’s Partnership Taxation Technical Resource
Panel. For more information about this article, contact Dr.
Karlinsky at karlin_s@cob.sjsu.edu or Dr. Burton at hughlene.burton@uncc.edu.

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